Productivity shocks and government budget deficits are considered to be two key determinants of the current account. This follows from basic accounting, which equalizes the current account and the difference between saving and investment. On the one hand, innovations to the government budget deficit will lower overall saving and the current account (to the extent that private saving and investment do not fully off-set the fall in public saving); on the other hand, productivity innovations, will have a positive impact on consumption and investment and lower the current account (to the extent that the effects on consumption and investment exceed the immediate effect of productivity on income).
Not surprisingly, productivity shocks and budget deficits have figured prominently in the policy debate on the secular decline of the current account in the U.S. In the mid-1980s, as a result of record current account and budget deficits the notion of ‘twin deficits’ became popular. In the mid-1990s, by contrast, the current account and the budget balance were moving in opposite directions. Consequently, general attention turned to productivity gains as the prime suspect responsible for the current account deficit. The early 2000s have again witnessed a strong deterioration in the U.S. fiscal position associated with a further decline in the current account such that the ‘twin deficits’ gained renewed attention. In sum, the informed analysis of current account developments during specific episodes seem to suggest an important role for productivity shocks and budget deficits.
Suggestive evidence, however, cannot make up for a rigorous analysis within a structural model. A natural framework for such an analysis is the intertemporal model of the current account, which has been tested successfully against the data in various modifications. Previous tests of the model, however, focused on the transmission of either productivity shocks or budget innovations. In the present paper, by contrast, we suggest a simple modification of the baseline intertemporal model such that i) both productivity shocks and the government budget govern the dynamics of the current account and ii) a tractable empirical specification can be obtained.
Specifically, we start from the version of the intertemporal model that Glick and Rogoff (1995) have shown to perform well empirically. Notably, the model correctly predicts that the current account falls in response to country specific but not in response to global innovations to productivity. Investment, by contrast, rises in response to both innovations. Glick and Rogoff also stress that one cross-equation restriction implied by the model is rejected by the data: under the assumption that productivity follows a random walk, the response of the current account (in absolute value) to a country specific productivity innovation should be higher than the response of investment.
Within the baseline intertemporal model used by Glick and Rogoff, however, there is no role for budget deficits since the financing of government spending is irrelevant (Ricardian equivalence holds completely). In order to relax this assumption, we proceed as suggested by Mankiw (2000) and assume that a fraction of households behave as spenders and spend their disposable income in each period, while the rest of the population behaves as savers and consumes its permanent income, thus smoothing resources intertemporally. We show, within the framework of Glick and Rogoff, how such a non-Ricardian feature leads to a modification of the reduced form of the model that can be tested against the data. Specifically, the country-specific component of changes in the government budget is shown to impact the current account in addition to the country specific productivity innovations. The extent of this effect depends on the weight of the spenders in the population.
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Productivity Shocks, Budget Deficits and the Current Account
